Informal Staff Advisory Opinion 96-5

This staff advisory opinion is issued in response to your request dated August 22, 1996, for our views concerning the possible retroactive application of the minimum payment requirement of the Franchise Rule, 16 C.F.R. § 436.2(a)(3)(iii).

I. INTRODUCTION

Your client intends to enter into a license relationship that arguably is covered by the Franchise Rule. You state that the only payment due within the first six months of operation is less than $500. At the same time, the licensee will be obligated to pay a "Deferred License Fee," which will be evidenced by a non-negotiable promissory note executed and delivered by the licensee to the licensor at the time the licensee signs the license agreement. You add that the promissory note, like the underlying obligation to pay the deferred license fee, matures "not sooner than six months after the date the licensee is obligated to commence operating the licensed business."

Under the license agreement, your client is obligated to provide training and to deliver confidential manuals and other proprietary information and support to the licensee within the first six month. Your client expresses concern about its ability to collect for services rendered, in the event a franchisee fails to open its business. If a franchisee were to breach its contract by failing to open for business, then the promissory note, in theory, would never become due because its precondition, opening for business, would not occur. On the other hand, if the franchisor files a breach of contract action and collects payment due, then such a payment will necessarily be made by the franchisee before he has conducted business for at least six months. Under the circumstances, you question whether the collection of the deferred fee might be considered a required payment retroactively, triggering the Franchise Rule's disclosure obligation.

II. THE MINIMUM PAYMENT EXEMPTION

The minimum payment exemption is available in limited instances when a franchisor can demonstrate that the aggregate of payments and commitments to pay made by a franchisee to the franchisor (or its affiliates) prior to and during the first six months of operation is less than $500.

In previous opinions, we have concluded that a deferred payment evidenced by a non-negotiable promissory notes may qualify for the minimum payment exclusion to the Franchise Rule. Non-negotiable notes create no significant financial risk for the franchisees because franchisees can assert defenses of non-performance and set-off in collection actions brought by the franchisor. See Advisory 95-10, Business Franchise Guide (CCH), ¶ 6475 at 9665 (December 8, 1995); Automobile Importers of America, Inc., Business Franchise Guide (CCH) ¶ 6382 (August 9, 1979).

At the same time, a financing arrangement containing an acceleration clause will not qualify for the exemption. Where a franchisee signs a note at the time of purchasing the franchise that enables the franchisor to accelerate the unpaid balance, the franchisee effectively takes upon himself a current obligation to pay the entire balance due. Such a binding commitment entered into at the time of sale is sufficient for Rule purposes. Advisory 95-10, Business Franchise Guide (CCH) at 9666.(1)

III. APPLICABILITY OF THE FRANCHISE RULE IS DETERMINED AT THE TIME OF SALE

As a matter of policy, Commission staff will determine Rule coverage by the reasonable expectations of the parties at the time they enter their franchise agreement. See Advisory 93-1, Business Franchise Guide (CCH) ¶ 6445 (March 3, 1993).(2) Where a franchisor agrees to a deferred payment by accepting a non-negotiable note due more than sixth months after the start of the franchisee's business, the franchisor reasonably can expect to take advantage of the Rule's minimum payment exemption. At the same time, we can reasonably conclude that the franchisee has declined the benefits of disclosure. Even if the franchisee was simply ignorant of its right to obtain a disclosure document, the franchisee is nonetheless protected. If, after operating the business for six months, the franchisee determines that the franchisor has failed to perform or otherwise misrepresented the nature of its franchise system, he nonetheless retains all defenses. Accordingly, we conclude that if the minimum payment exemption applies at the time of the franchise sale, post-sale changes of events will not render the exemption inapplicable retroactively.(3)

IV. COLLECTION OF PAYMENT DUE FOR BREACH OF CONTRACT IS NOT A REQUIRED PAYMENT

We also find that the collection of a deferred payment in an action brought by a franchisor against a franchisee for failing to open its business in breach of its contract cannot be considered a required payment within the meaning of the Franchise Rule. Section 436.2(a)(2) defines the minimum payment requirement as follows: "The franchisee is required as a condition of obtaining or commencing the franchise operation to make a payment or a commitment to pay to the franchisor, or to a person affiliated with the franchisor." The concern expressed in your letter is that the franchisor might not be able to seek damages for services rendered if the franchisee has breached its contractual obligation to open an outlet. If a franchisor successfully sues and collects a judgment of the deferred payment, despite any defenses the franchisee may raise, then it cannot reasonably be said that such a judgment is "as a condition of obtaining or commencing the franchise operation." Just the opposite would be true: the very reason the franchisor has collected the judgment is that the franchisee has failed to commence the franchise operation. Under such circumstances, the collection of the judgment cannot reasonably be said to constitute a required payment within the meaning of the Rule.

V. CONCLUSION

For these reasons, we conclude that a franchisor may seek to collect a judgment for services rendered where a franchisee breaches its contract by failing to open for business. Where the parties to a franchise agreement agree to a deferred payment (in the absence of a written acceleration clause), the unanticipated, premature collection of that payment does not become a required payment retroactively. Moreover, because the collection of payment in such a situation results from the franchisee's failure to open for business, it is not reasonable to say that such payment is a "required payment" for the purpose of commencing operation of the business, as the Rule contemplates.

Please be advised that our opinion is based on all the information furnished in your request. This opinion applies only to your client and to the extent that actual company practices conform to the material submitted for review. Please be advised further that the views expressed in this letter are those of the FTC staff. They have not been reviewed, approved, or adopted by the Commission, and they are not binding upon the Commission. However, they do reflect the opinions of the staff members charged with enforcement of the Franchise Rule.

Date: November 15, 1996
Franchise Rule Staff

1. For purposes of this advisory, we will assume that your client does not intent to include a written acceleration clause in its financing agreement with licensees.

2. See also Advisory 93-12, Business Franchise Guide (CCH) ¶ 6456 at 9636 (January 28, 1994).

3. For purposes of this advisory opinion, we assume that the franchisor's suit to collect payment against the franchisee is an isolated event. Where a number of franchisees fail to open for business and the franchisor exhibits a pattern or practice of bringing suit against the franchisees for breach of contract, then we might find that the franchisor, at the time of entering into the franchise agreements, intended to collect on the promissory notes prematurely. In such instances, we can reasonably conclude that the deferred payment was a sham and, therefore, the minimum payment exemption was inapplicable at the time of sale.